1. slide 0 Money supply measures, April 2002 _SymbolAssets includedAmount (billions)_ CCurrency$598.7 M1C + demand deposits,1174.0 travelers’ checks, other checkable deposits M2M1 + small time deposits,5480.1 savings deposits, money market mutual funds, money market deposit accounts M3M2 + large time deposits,8054.4 repurchase agreements, institutional money market mutual fund balances

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6. slide 5 The social costs of inflation …fall into two categories: 1. costs when inflation is expected 2. additional costs when inflation is different than people had expected.

7. slide 6 The costs of expected inflation: 1. shoeleather cost  def: the costs and inconveniences of reducing money balances to avoid the inflation tax.      i   real money balances  Remember: In long run, inflation doesn’t affect real income or real spending.  So, same monthly spending but lower average money holdings means more frequent trips to the bank to withdraw smaller amounts of cash.

8. slide 7 The costs of expected inflation: 2. menu costs  def: The costs of changing prices.  Examples: –print new menus –print & mail new catalogs  The higher is inflation, the more frequently firms must change their prices and incur these costs.

9. slide 8 The costs of expected inflation: 3. relative price distortions  Firms facing menu costs change prices infrequently.  Example: Suppose a firm issues new catalog each January. As the general price level rises throughout the year, the firm’s relative price will fall.  Different firms change their prices at different times, leading to relative price distortions…  …which cause microeconomic inefficiencies in the allocation of resources.

10. slide 9 The costs of expected inflation: 4. unfair tax treatment Some taxes are not adjusted to account for inflation, such as the capital gains tax. Example:  1/1/2001: you bought $10,000 worth of Starbucks stock  12/31/2001: you sold the stock for $11,000, so your nominal capital gain was $1000 (10%).  Suppose  = 10% in 2001. Your real capital gain is $0.  But the govt requires you to pay taxes on your $1000 nominal gain!!

11. slide 10 The costs of expected inflation: 5. General inconvenience  Inflation makes it harder to compare nominal values from different time periods.  This complicates long-range financial planning.

12. slide 11 Additional cost of unexpected inflation: arbitrary redistributions of purchasing power  Many long-term contracts not indexed, but based on  e.  If  turns out different from  e, then some gain at others’ expense. Example: borrowers & lenders If  >  e, then (i   ) < (i   e ) and purchasing power is transferred from lenders to borrowers. If  <  e, then purchasing power is transferred from borrowers to lenders.

13. slide 12 Additional cost of high inflation: increased uncertainty  When inflation is high, it’s more variable and unpredictable:  turns out different from  e more often, and the differences tend to be larger (though not systematically positive or negative)  Arbitrary redistributions of wealth become more likely.  This creates higher uncertainty, which makes risk averse people worse off.

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15. Recent episodes of hyperinflation slide 14